Shrink the eurozone to save it

A riot policeman tries to avoid a petrol bomb after clashes erupted during a general strike that halted services and disrupted flights May 11, 2011 in Athens, Greece. Protestors reportedly clashed with riot police throughout Athens after unions called the strike to protest harsh austerity measures intended to keep the debt-ridden country solvent.

With each passing day, Greece’s economic and political malaise deepens despite one massive International Monetary Fund-European Union bailout package after another to keep that country afloat. And with each passing day, as the Greek economy continues its downward spiral under the weight of externally imposed draconian budget austerity, there is the increased risk that a disorderly Greek euro exit could result in real contagion to the rest of the European periphery and especially to Italy, an otherwise solvent country.

This has to raise a basic question: Would not the European core countries be better served by proactively taking action now to form a smaller and more enduring currency union than the present eurozone? And would such action not be preferable to continuing with the pretense that the euro can be preserved in its present form, which runs the real risk of a disorderly and costly unraveling of the common currency?

Sadly, the IMF and EU’s heroic, if quixotic, efforts to keep Greece afloat with a second 130 billion-euro bailout package that has now finally been agreed upon, are all too suggestive that European policymakers remain in denial that Greece will soon be forced to exit the euro.

This is all the more lamentable since there is virtually no prospect the IMF’s present prescription of further hair-shirt fiscal austerity within Greece’s euro straightjacket is going to be any more successful in stabilizing the Greek economy than was the application of the same policy prescription over the past two years.

One would have thought by now that the IMF and Europeans would have grasped how politically unsustainable is their Greek policy prescription, particularly considering that the Greek economy is now in a virtual state of collapse.

“One would have thought by now that the IMF and Europeans would have grasped how politically unsustainable is their Greek policy prescription, particularly considering that the Greek economy is now in a virtual state of collapse.”- Desmond Lachman

January’s European Summit also provides the strongest of evidence that European policymakers seem to have learned little from their unfortunate Greek experience. For rather than recognize that the internal and external imbalances of countries such as Greece, Portugal, Ireland and Spain have reached such large proportions that make it almost inevitable these countries will be forced both to default and to exit the euro, European policymakers are striving to preserve the euro very much unchanged in its present form.

They are doing so by proposing that all countries should adopt constitutional balanced budget amendments and sign up to legally binding budget-deficit reduction programs that are to be externally monitored. It is supposed that after several years, once the desired degree of deficit reduction is eventually attained, the present monetary union could move toward a full fiscal union that would provide the firmest of underpinnings to the existing currency union.

The fly in the ointment is that to reduce the large public-sector imbalances in the European periphery would require the early restoration of economic growth in those countries.

However, the severe public-sector belt-tightening across all euro-member countries (within the constraints of euro membership that precludes currency devaluation as a way to boost exports) is a sure recipe for a deep and prolonged European recession. And as Greece’s experience over the past 18 months would attest, a deepening economic recession puts deficit-reduction targets well out of reach, increases a country’s public-debt service burden and heightens political opposition to staying the austerity course.

The futility of excessive budget austerity in a fixed exchange rate system is especially the case when one considers the overall European economy is already showing signs of considerable weakness and when the envisaged degree of budget tightening is extraordinarily large. It is for example being proposed that Italy undertake budget cuts and revenue increases amounting to nearly 2 percentage points of gross domestic product a year in each of the next two years, while for Greece, Ireland, Portugal and Spain the proposed budget adjustment is more on the order of 3 percentage points of GDP a year in 2012 and 2013.

At the best of times, attempting to apply multiyear budget adjustment of such a large scale would run the risk of a prolonged and deep economic recession. However, these are not the best of times in Europe given a weak external economic environment and the likelihood of a European credit crunch over the next year as European banks sell assets and restrict credit in an attempt to strengthen their balance-sheet positions.

As if to underline the futility of severe budget tightening in a fixed exchange rate system, for the year ahead the IMF is forecasting a serious deepening in the European periphery’s recession. The most disturbing aspect of the IMF’s latest economic forecast is that Italy and Spain, Europe’s third- and fourth-largest economies, are both expected to shrink by around 2% in 2012. This is almost certain to cause large budget-deficit overruns in both of these countries and to raise questions anew in the markets about these two countries’ debt sustainability.

Against this background of a slow-motion European train wreck one has to wonder whether Germany, France and the other north European-member countries should not avail themselves of those provisions of the Lisbon Treaty that allow countries to exit the union voluntarily. Doing so in unison would afford them the opportunity to bind themselves in a new currency union with stronger underpinnings than the current currency union, including an early move to a true fiscal union that might involve the joint issuance of euro bonds.

A significant though not insurmountable legal obstacle to the formation of a new smaller currency union among the stronger northern European economies is posed by the existing Lisbon Treaty. While that treaty provides that while countries can exit the present currency union either individually or in unison, doing so would require them to leave the EU as well. For that reason, should the core countries decide to leave the currency union in unison they would also need to approve a parallel treaty rapidly, which would provide for the maintenance among themselves of the same present trade arrangements that they have within the EU. Such a course of pre-emptive action would certainly be preferable to a disorderly breakup of the current monetary union.